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A fresh approach to rethinking investing

28 August 2017 Jonathan Faurie

It is often argued that historical investment performance gives no indication of what might happen in the future. However, experience shows that the future will, most likely, fall within the boundaries set by long-term history.

This is the statement which frames most investment decisions. It gave rise to the popularity of active managers and is the statement which currently fuels the debate about the underperformance of these same individuals. 

FAnews spoke to George Herman, CIO at Citadel, to find out more about what the investment outlook currently looks like for investors. 

Smart beta saviour

While finding alpha has been elusive, active fund managers have turned to smart beta in the hope of trying to find good investment options. 

“It was a major breakthrough when the asset management industry started referring to alpha separately from Beta, which was always considered ‘the market’.  As soon as this happened, the world started its search for Alpha and it immediately became the Holy Grail.  No sooner did active managers and hedge funds claim their grasp of and ability to generate consistent Alpha, when a new trend emerged,” said Herman. 

He added that eventually Beta itself became commoditised.  Suddenly the more important question became: what is the market and can it be replicated?  “Various methods and indices can be used to represent a market or a sub-sector of a market and suddenly a plethora of Beta became available.  Active managers were now able to buy passive beta and in so doing instantly gain access to very targeted Beta,” he said.

 What constitutes the index?

Herman then asked that if Beta is purely tracking an index, the next question becomes:  what constitutes an index?  

“Can an index be created to represent a theme or risk factor, rather than a subjective industry classification?  Absolutely said the quantitative analysts, and right there and then the genie was out the bottle.  Can I have an index that represents or contains value stocks for instance?  Yes they said and after some furious keyboard tapping, an algorithm was defined to filter for, rank and weight stocks according to various characteristics.  Factor indices can thus also be replicated,” said Herman. 

He added that these indices are not passive however; as they have to be rebalanced frequently to maintain the required characteristics post market moves.  This is a repetitive, defined process and perfectly suited to be handed over to a small group of people with some serious computing power.  

“A new industry of providing access to different kinds of Beta was born.  Many people call it many different things: Alternative Beta; Active Beta; Quantitative Beta; Scientific Beta and also Smart Beta.  I reckon that is an unfortunate choice as calling something smart usually is not smart. 

Key movements

Because of the underperformance of active fund managers, there has been some movement away from them towards passive fund managers. Will this trend continue? 

The strong trend globally, away from actively managed funds towards passively managed offerings, will in all likelihood continue in the future, but probably not at the same pace as we have seen in recent years. The continuous, and growing, interest in passively managed offerings that has been witnessed over the last number of years followed a particularly challenging period since the global financial crisis (GFC) for active managers globally. This was, inter alia, caused by the wave of money (quantitative easing) thrown onto, and into, markets by global central banks in an attempt to stimulate activity and support their respective economies,” said Herman.  

The investment industry was the worst hit after the GFC, and active managers were major casualties in this. Whether it will continue remains to be seen. However, it seems as if smart beta is the investment of the future. 

Editor's Thoughts:
The debate around active investment strategies, and the struggle that active fund managers have to find alpha, will dominate the industry for years to come. With the focus being on hard beta, perhaps the industry has found a way to inspire confidence in the industry again. This remains to be seen. Please comment below, interact with us on Twitter at @fanews_online or email me your thoughts jonathan@fanews.co.za.

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